This Time Around, this Country's Stocks May Not be Immune to Foreign Policy

If you go back and trace the ups and down of the Israeli stock market, you’ll find almost no correlation with the broader conflicts taking place in the region. Shares on the Tel Aviv stock exchange slump when Hamas or Hezbollah pounds the war drums, but invariably bounce back. History has shown that the trading direction from Israeli companies is more closely tied to the performance of the Nasdaq (thanks to that country’s large concentration of tech companies), and the broader health of the Israeli economy.

As tech stocks have moved back into favor during the past year, and the Israeli economy posts solid growth rates and little inflation, share prices have posted significant gains. The iShares MSCI Israel ETF (NYSE: EIS), which owns a basket of Israeli stocks that trade on the Tel Aviv stock exchange, doubled to $60 during the period from March 2009 to April 2010. More recently, the exchange-traded fund (ETF) has pulled back to around $50, in tandem with other markets. But this time around, investors shouldn’t assume that there'll be another rebound when the Nasdaq rises anew.

That’s because recent events in Israel can’t be dismissed as “more of the same.” Although the country does little business with its Middle Eastern neighbors, Europe represents a massive market for the country’s agriculture and technology exports. The reaction to this weekend’s events off of the Gaza strip have incited so much anger across Europe that consumers and businesses may start to throttle back Israeli imports. Tourism, which is also a key source of foreign earnings, may suffer in the coming year due to these events.

It’s hard to understate the importance of Israeli exports. The small country, which has a limited amount of natural resources, heavily relies on imports to meet its transportation, construction and power generation needs. If Israel’s exports slump and tourism recedes, the country would be faced with rising trade deficits, which would likely lead to inflation. And inflation has been one of the key factors holding back Israeli stocks in the past.

Israeli companies such as Teva Pharmaceuticals (Nasdaq: TEVA) should emerge relatively unscathed as the large majority of its sales are derived in the United States. But domestic-focused companies such as wireless service provider Cellcom (Nasdaq: CEL) could take a real hit if the Israeli economy slumps and its citizens need to tighten their belts.

The current crisis could also bring opportunity. Peace efforts have gone nowhere in recent years, in part due to a lack of perceived urgency. This current crisis is likely to draw much more attention from leaders in Europe, Canada and Australia. Their engagement may bring about a push to calm the current crisis while moving the peace process forward. And if Israel can eventually achieve some sort of peace, its impressive base of technology could find a place in more countries, as boycotts recede. That seems like a long shot, but hope springs eternal.

Action to Take --> Israeli stocks are falling Tuesday for the fourth straight session. As the ramifications of the current crisis become clearer, shares could fall by a further considerable amount. If you have exposure to Israeli stocks such as Teva or Cellcom, you may want to hedge that exposure by shorting the iShares MSCI Israel ETF.